Oil-rich Russia battles the global economic crisis

Recovery tied to price of oil, natural gas and other commodities

By

PolyaLesova

MOSCOW (MarketWatch) -- Soaring in this capital's business district, the Naberezhnaya Tower, an office complex of three buildings of varying height, is a symbol of Russia's ambition. It is ultra-modern and lavish.

The 51st floor of its tallest building affords a dizzying view of Moscow -- cars hurrying on the highways like ants and, in the distance, dozens of apartment blocks dating back to Soviet times. Nearby, unfinished skyscrapers and idle construction cranes remind visitors that a recent economic boom has been abruptly interrupted.

Skyrocketing commodity prices brought unprecedented prosperity to oil-rich Russia over the past few years. Annual growth averaged 7% and Moscow earned a reputation as one of the world's most expensive cities.

A middle class emerged with an appetite for luxury goods. Presiding over business empires mostly tied to resources, Russian oligarchs like Roman Abramovich and Oleg Deripaska became synonymous with extreme wealth, going on shopping sprees for foreign assets, including British football clubs.

"When commodities were skyrocketing, they [Russians] thought they were kings of the world. They disregarded the rights of minority and foreign investors. Now a lot of people say that Russia is tradable, but not investable."
Mariusz Adamiak, Pioneer Investments

Then, suddenly, the economy hit the wall last fall as oil prices collapsed from a record high near $150 a barrel. Demand for oil, natural gas and metals -- the lifeblood of the economy -- dried up.

Overleveraged oligarchs saw billions of dollars of net worth disappear in a matter of months. There were deposit runs on banks, as fear of sharp ruble devaluation sent people rushing to change ruble deposits into dollars and euros. Foreign investors fled, precipitating a collapse in equity prices.

The Russian economy, which contracted by 9.5% in the first quarter, is expected to decline by 6.5% this year and to remain stagnant in 2010.

The government has become a lender of last resort to many companies and banks, increasing already strong state influence over the economy.

Concern over nonperforming loans in the banking sector is mounting, and the International Monetary Fund warned recently that a comprehensive plan to address bad assets and capital shortfalls is urgently needed.

"What the crisis has fundamentally revealed is that Russia has a weak banking sector and weak domestic capital markets," said Roland Nash, head of research at Renaissance Capital in Moscow. "There's not a very deep ruble market at all. That's why you see such huge volatility in Russian asset prices."

But after tumbling 74% in 2008, the MSCI Russia stock index has rallied 69% this year, tracking a rebound in oil prices and an improvement in global market sentiment. Now, investors are wondering whether the equities rally is sustainable and when an economic recovery might begin.

Elina Ribakova, chief economist at Citigroup in Moscow, expects the second quarter to be the worst amid a sharp slowdown in consumption, a main factor behind Russian growth in recent years.

"The risks are as bad as a 10% contraction for the year as a whole," Ribakova said. "If we see zero growth next year, I'd call it a successful stabilization."

Boasting vast reserves of natural resources, Russia is the world's biggest exporter of natural gas and the second biggest exporter of oil. It is also a major exporter of metals. Oil prices have surged more than 50% over the last three months and are currently near $70 a barrel.

"The crisis showed clearly that Russia still means oil and gas," said Mariusz Adamiak, senior fund manager at Pioneer Investments in Austria. "If oil and gas hold at current levels, Russia will escape the worst. [However,] Russia is still a very inefficient economy. Innovation is not a major source of success. It's a highly corrupt country."

Corruption, a weak judicial system and lack of trust in institutions have long plagued Russia. Out of 180 countries, Russia ranked 147th on Transparency International's 2008 Corruption Perceptions Index. Its score was 2.1 on a scale from zero (highly corrupt) to 10 (highly clean).

Before the global financial crisis hit, Russia's economy was geared for extreme growth amid skyrocketing commodity prices, with money pouring in "from every possible window and door," as one long-time observer put it.

Under the watch of Vladimir Putin, former president and now prime minister, Russia played an increasingly assertive role on the global political stage, expanded its influence in the countries that were part of the former Soviet Union, and dramatically deepened the involvement of the state in strategic economic sectors, such as oil and gas. A series of high-profile cases -- including Yukos and Mechel
MTL, -3.04%
-- highlighted that shareholder wealth can be easily destroyed through political attacks.

"When commodities were skyrocketing, they [Russians] thought they were kings of the world," Adamiak said. "They disregarded the rights of minority and foreign investors."

"Now a lot of people say that Russia is tradable, but not investable," he continued. "They mean it's unpredictable. Every investment decision can change overnight because of a political decision. It's practically always an insider game. It's a deadly mistake for Russia long-term."

Bank troubles cloud outlook

Russia currently faces a number of challenges, including recapitalizing the banking sector, restructuring the corporate sector, and dealing with unemployment.

"In the fall, we really had the possibility for a systemic failure," said Jyrki Talvitie, chief representative of East Capital in Moscow. "There was panic in the market and that's something that as investors you can't fight against. That fortunately has subsided and now we're looking at the NPLs [nonperforming loans] as the main problem. But that's something you can work with. It's not just holding your breath and seeing whether the whole system falls."

Moody's Investors Service has said that the current level of nonperforming loans in Russia has likely more than doubled to 11% of total loans at the start of the second quarter of this year, from 4.6% in early 2008.

An additional 10% to 15% of loans have been restructured to avoid payment default, according to Moody's. By the end of the year, the ratings agency expects that NPLs could increase to 20%.

"The government has been incredibly active at pushing money into the system and using the state-owned banks to do so," Nash said. "What would otherwise have been defined as a nonperforming loan has been rolled over by the state. The scaremongering that NPLs could rise to 15% or 20% is very unlikely, not because all companies can pay but because there will be someone who will be willing to lend to them."

Andrey Shalimov, head of treasury at mid-sized Vozrozhdenie Bank, said that the asset quality of Russian banks differs widely, with nonperforming loans varying from 5% to 40%.

"Some big private banks could count as much as 40% NPLs by the end of the first half," Shalimov said. "[However,] there are a number of banks with good quality assets. For them, it's a time to grab some additional market share."

In addition to the problems in the banking sector, unemployment is another major challenge for the government. The official unemployment rate has climbed to 10.2%, raising the specter of social unrest. The situation is particularly acute in so-called mono-towns that rely on a single industry, such as coal or metals.

Unemployment "would be much higher if you didn't have these informal ways of getting around it," Nash said. "It's been very easy for companies to cut wages rather than fire people and that's the tradition in Russia. Also, the government can really put a lot of pressure on firms not to fire people...even when you have this huge shift in demand."

Despite the economic pain, the likelihood of widespread social unrest is low, observers said. In comparison with the 1998 debt default and the collapse of the Soviet Union nearly two decades ago, the current crisis is "pretty minor," Nash said.

Russian people are "extremely resilient," Talvitie said, but "what makes this time a little different than before is you had already quite fast growing middle class -- people who suddenly got used to new apartments, cars, traveling."

That segment of the population has been very inactive politically, but that could change if their standard of living goes down dramatically and they don't see a way out, he said.

Shalimov of Vozrozhdenie Bank said that it's very worrying to observe the change in people's perception of their future.

"For a significant part of the population, it was a period of constant decline from late 1980s to early 2000s, and then they experienced at least three to four years of growth," Shalimov said. "And now the situation changed again -- it could be very difficult psychologically. People were prepared for one year of tough times, but now there are some prospects of three to five years of tough times. And many of them could be tempted to be out of business."

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